Professional Documents
Culture Documents
■ ALM: Introduction
■ Risks faced by insurance companies
■ Basic financial tools
■ ALM - Deterministic methods
■ ALM – Stochastic methods
2018-2019 1
Risks faced by insurance companies
■ The market consistent value of assets and liabilities is typically a function of underlying
« risk factors »
■ Mathematically, it means that the assets value !" and technical provisions #$" at a
future instant t are function of these risk factors:
!" = !" ", '(" , … , '*" , #$" = #$" ", '(" , … , '*" ,
■ The variation in the values of assets and liabilities over a certain time horizon depends
hence on:
● The variation of the values of these underlying risk factors
● The sensitivity of the assets and liabilities values to a given change in these underlying
risk factors
■ A loss is hence the result of an adverse variation of one or several of these risk factors
■ It is important in ALM to understand for the different types of assets and liabilities to
which risk factors they are sensitive as the role of ALM is precisely to manage the
mismatch in sensitivities of assets and liabilities
Risks of Insurance Companies 2018-2019 2
Risks faced by insurance companies
Financial losses,
Increase of rates in Selling assets at a potential difficulties
Massive surrenders
the market lower price for remaining
contracts
Risks of Insurance Companies 2018-2019 5
Market Risks: FX risk
■ FX risk
● Risk associated to variations in the market of foreign exchange rates
● Solvency II definition: Risk of losses resulting from changes in the level or
volatility of FX rates.
● The risk is present in particular when covering assets and insurance
liabilities are denominated in different currencies
● Also called “currency risk”
0.035 0.035
0.03
0.03
0.025
0.025
0.02
0.02 0.015
0.015 0.01
0.005
0.01
0
0.005
-0.005
0 -0.01
0 10 20 30 40 50 60 70 80 90 0 10 20 30 40 50 60 70 80 90
■ Equity risk
● Risk linked to variations in the market of stocks prices and dividends
returns
● Solvency II definition: Risk of losses resulting from changes in the level or
volatility in the equity prices (including the prices of the equities listed in
stock exchanges, the non-listed equities, the private equities, hedge
funds, commodities, mutual funds (e.g. real estate funds), and other
alternative investments)
● Potentially affecting the return on the asset side of the company
■ Real estate (or property) risk
● Risk linked to variations in the market of real estate prices and returns
● Solvency II definition: Risk of losses resulting from changes in the level or
in the volatility of the market prices of real estate (land, building owned by
the insurance company
● Potentially affecting the return on the asset side of the company
Risks of Insurance Companies 2018-2019 9
Market Risks
■ Remark
● The different market risks are not independent
● For instance, the level of interest rates are generally negatively correlated
with equity prices
● But sometimes, we observe the opposite: positive correlation.
Ó Decrease of the equity market simultaneously with decrease of interest rates, in case
of violent crisis
Ó In a crisis situation, investors have less confidence in the stock market à demand for
government bonds (and good corporate bonds) increases, simultaneously with a
decrease of the stock market (fly to quality)
● We sometimes speak about “dependency risk”, or see dependencies
themselves as a risk factor
0.005
0.015
0.025
0.035
50.00
100.00
150.00
200.00
250.00
300.00
350.00
2/01/2002
2/01/2002
2/03/2002
2/03/2002
2/05/2002
2/05/2002
2/07/2002
2/07/2002
2/09/2002
2/09/2002
2/11/2002
2/11/2002
2/01/2003
2/01/2003
2/03/2003
2/03/2003
2/05/2003
2/05/2003
2/07/2003
2/07/2003
Euribor 1W
Eurostoxx 600
2/09/2003
2/09/2003
2/11/2003
2/11/2003
2/01/2004
2/01/2004
2/03/2004
2/03/2004
2/05/2004 2/05/2004
2/07/2004 2/07/2004
2/09/2004 2/09/2004
2/11/2004 2/11/2004
Market Risks – Dependencies - Illustration
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11
0
0.01
0.02
0.03
0.04
0.05
0.06
-
2/01/2002
50.00
100.00
150.00
200.00
250.00
300.00
350.00
400.00
450.00
2/01/2002 2/05/2002
2/05/2002 2/09/2002
2/09/2002 2/01/2003
2/01/2003 2/05/2003
2/05/2003 2/09/2003
2/09/2003 2/01/2004
2/01/2004 2/05/2004
2/05/2004 2/09/2004
2/09/2004 2/01/2005
2/01/2005
2/05/2005
2/05/2005
2/09/2005
2/09/2005
2/01/2006
Euribor 1W
Eurostoxx 600
2/01/2006
2/05/2006
2/05/2006
2/09/2006
2/09/2006
2/01/2007
2/01/2007
2/05/2007
2/05/2007
2/09/2007
2/09/2007
2/01/2008
2/01/2008
2/05/2008 2/05/2008
2/09/2008 2/09/2008
2/01/2009 2/01/2009
2/05/2009 2/05/2009
Market Risks – Dependencies - Illustration
correlation cycles
2008 is positive
à Negative or positive
► Correlation on 2007-
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12
Market Risks - Specific risks (1/2)
§ Liquidity risk
§ Risk that the insurance company, although solvent, has not sufficiently
liquid assets (that can be sold immediately at a fair price) in order to face
the payment of cash-flows when they are due
§ This may force the company to sell assets at unfavorable prices
§ Risk to make a loss when selling an asset at a low price, because of its lack of liquidity
§ Risk of having not sufficient treasury, and being obliged to sell less liquid assets
§ This might occur in the case of unexpected large claims (catastrophe events) or
confidence crisis of policy holders (massive surrenders)
§ Another type of liquidity risk is the risk to face losses due to lack of liquidity
in the market
§ If all markets are liquid, the different actors in the market will continuously set up
arbitrage operations in order to all markets aligned (bonds, swap, CDS… markets)
§ During financial crises, this arbitrage disappears and questions regarding the
activity/liquidity of the different markets arise
§ Introduction of a liquidity spread by companies for valuing their assets, and potentially
their liabilities
Risks of Insurance Companies 2018-2019 13
Market Risks - Specific risks (2/2)
§ Concentration risk
§ Many types of concentration can exist: name (counterparty), geographical,
industry
§ Name concentration:
§ Risk of important losses caused by the default or downgrade of one particular name, in
which an important part of the assets have been invested (SII)
§ Linked with counterparty risk
§ Idiosyncratic risk
§ Risk of losses from variations of a particular asset, where the variations are
not linked with the general movements observed on the market
§ E.g. Risk to observe movements of a particular stock, while not observed in the market
in general, due to specific event
§ The risk may be important in the case of a not sufficiently diversified
portfolio
• European Insurance and Occupational Pensions Authority : independent advisory body to the European Parliament and the Council of the European
Union. Core responsibilities : support the stability of the financial system, transparency of markets and financial products as well as the protection of
insurance policyholders, pension scheme members and beneficiaries. One of the main aims for the coming years : preparation of the new supervisory
regime for insurance and reinsurance undertakings , and particularly the conduct of all the necessary work for the implementation of the Solvency II EU
Directive (see https://eiopa.europa.eu/home/index.html)
§ In Life/Health Insurance:
§ Longevity/Mortality Risks: The risk of losses resulting from a difference in mortality rates.
§ Expense Risk: The risk of losses resulting from a difference in incurred expenses.
§ Disability/Morbidity Risk: The risk of losses resulting from a difference in disability,
sickness and morbidity rates.
§ Life catastrophe Risk: The risk of losses due to catastrophic events (epidemy,..)
§ In Non-Life Insurance:
§ Premium Risk: The risk of losses due to difference in the timing, the frequency or the
severity of the claims.
§ Reserve Risk: The risk of losses due to difference in the timing and the amount of claims
settlements (for the claims outstanding).
§ These two risks also include the losses due to changes in the consumer price inflation
rates as well as the claims and expenses specific inflation.
§ Non-Life Catastrophe Risk: The risk of losses due to catastrophic events (floods,
earthquakes, windstorms, etc.)
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Counterparty default / Credit risk
■ Solvency II definition:
● The risk of losses resulting from unexpected defaults of counterparties or debtors of the
insurance company (default of corporates/government bonds, default of reinsurers, default
of OTC derivative counterparties,...)
■ Risk of default or downgrade of a counterparty
● Reinsurers (reinsurance contracts) or SPVs (securitisation contracts)
● Banks (financial derivatives)
● Corporates (loans and bonds)
■ Risk to face financial losses resulting from the default or change of credit quality
(migration) of a security issuer or a counterparty
● Default risk : cash-flows will not be received anymore or only part of them (recovery rate is
in general positive) or later
● Migration risk: risk of modification of the credit quality, leading to a decrease of the value of
the bond or contract concluded with that counterparty
■ In particular, for corporate bonds, the event causing the loss is the default of the issuer
or its downgrade, and not variations of the spread in the market (≠ spread risk)
Risks of Insurance Companies 2018-2019 17
Operational Risk
§ Definition
§ “Risk of loss arising from inadequate or failed internal processes, or from employees and
systems, or from external events. Operational risk should include legal risks, and exclude
risks arising from strategic decisions, as well as reputation risks”
§ Introduced by the Basel Committee in the banking industry (Basel II)
§ Solvency II considers also that insurance companies need to hold a specific amount of
capital for that risk
§ Modelling
§ Simple close formula in the standard formula of Solvency II
§ Internal model approach : difficult, and will take time in the insurance industry
§ Lack of sufficient data for modelling this type of risk
§ Most of the capital is actually driven by catastrophic event types, which are difficult to model
§ Need for building internal and external databases (like ORX)
● Policy loan options that allow the policyholders to borrow, at any time, at
specified terms, against the reserve of an insurance policy
● A renewal privilege that offers policyholders the right to either renew the
insurance contract at pre-specified rates or to stop the agreement at the
end of the contract period
■ The policyholders have the choice and not the obligation to exercise
these options
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Characteristics of liabilities: embedded options
■ These options provides additional flexibility to the policyholders and as such have (in
principle) a positive value
■ The value of these options should be taken into account in the value of the technical
provisions
● Otherwise, the financial leverage would be underestimated and thus the overall insolvency risk
underestimated as well
■ When assessing the sensitivity of the value of the technical provisions to the different risk
factors, the sensitivity of the value of these options should of course also be taken into
account
● The sensitivity can potentially be high as the value of an option is a nonlinear function of the
underlying
■ Neglecting the sensitivity of the value of these options in ALM can lead to a mismatch
between the assets and the liabilities.
■ The same holds for the assets as they can also include optional features. For example:
● Financial derivatives/Options
● Callable bonds
● Prepayment options in the mortgages